The Dragon is Ravenous

While food is necessary for survival, energy is necessary for growth…and no country is growing at a faster clip than China. Their demand for energy increases everyday, and Justice Litle explores their strategies to ensure energy security.

China’s oil demand has doubled over the past decade, and the pace is only increasing. There will be ups and downs along the way: When the current infrastructure boom and the flood of foreign investment slow, energy demand will slow for a time also. But in the long run, the trend is inexorably steep. Consider this from The Economist (from "The Hungry Dragon," September 2004):

"In around 20 years’ time, China’s income per person could be close to South Korea’s today. If its energy consumption per person also rose to current South Korean levels, its energy demand would quadruple. The increase alone would be greater than America’s total consumption today, yet China’s energy use per person would still be only half that in America. At present there is only one car for every 70 people in China, against one car for every two Americans. If car ownership were eventually to rise to American levels, there would be 650 million cars on Chinese roads – more than all the cars in the world today."How is China going to ensure energy security with such a tall order to fill, let alone generating capacity for such incredible demand? First, by developing strategic ties with key energy producers who prefer an alternative to the "Bush doctrine" of the United States; second, by investing in local production and alternative energy sources that will reduce reliance on imports over time.

With key producers like Venezuela and Russia already in place, and with Canada as a long-term energy source, China’s secondary focus is on alternative energy.

China’s Energy Needs: Upgrading and Investing in Advanced Technology

Through development of local resources and investments in cutting-edge technology, China can further close the energy gap and reduce dependence on outside partners. To this end, China is upgrading its nuclear power capabilities and investing heavily in advanced technology that will turn coal into petroleum products. It is in this area where Western investment opportunities remain; while it is not feasible to invest in the Venezuelan or Russian governments, China cannot avoid partnering with Western companies when access to technology is required.

Nuclear power is a natural choice for China. The standard "green" objections to nuclear power simply do not exist in the Middle Kingdom. Furthermore, China has awful problems with water shortages, air pollution and acid rain. A nuclear alternative could remedy some of these issues by substituting nuclear energy for fossil fuels and removing stress from the environment. Nuclear power has another green aspect as well: It produces virtually zero carbon dioxide, and thus does not contribute to global warming.

China has plans to develop a new type of reactor design known as a PBMR, or pebble bed modular reactor. The pebble bed reactor is theoretically cheaper and easier to build than traditional PWR (pressurized water reactor) plants. The pebble bed reactor also has a safety edge in that it is supposedly "meltdown proof": The reactor’s uranium "pebbles" (actually the size of billiard balls) are coated with high-density carbon, preventing exposure in the event of a coolant leak. Thus, in theory at least, the disasters of Chernobyl and Three Mile Island could not happen with a PBMR. Furthermore, because the pebble bed reactor design is modular, extra generating capacity can be added over time, allowing for further development as needed and less lump sum expense for initial construction.

China is in competition to develop the first commercially viable pebble bed reactor with a consortium led by Eskom, South Africa’s state-run utility firm. Eskom claims to have a lead in technological development over China, but an environmental challenge in the South African courts has created a legal hurdle Eskom must clear. (China, of course, does not have to trifle with those annoying bits of democracy that oppose national interest.) First-mover advantage is a potentially valuable prize, with the opportunity to license PBMR technology and construction to other countries hungry for an inexpensive and safe energy source. Eskom may still be in the running for a commercial product even if China gets there first; while China’s main focus will be developing a new energy source quickly and building rapidly, Eskom’s niche could be in developing more safeguards and design efficiencies, worth the larger price tag for more prosperous (and litigious) societies, where any nuclear solution must meet stringent high standards.

China’s Energy Needs: Coal Liquefaction

On another experimental front, China is spending more than $3 billion on a coal-liquefaction plant in Inner Mongolia. The Shenhua Group, China’s largest coal producer, has partnered with a U.S. technology provider to convert coal into petroleum products. In a nutshell, the process involves breaking coal down into hydrogen-enriched molecules, which are then converted to traditional oil products. According to Zhang Yuzhou, vice president of Shenhua Group, "The project consists of two phases of construction, and after the second is complete, the plant aims to yield 5 million tons of oil products annually and greatly reduce China’s reliance on crude oil imports."

The economic viability of coal liquefaction hinges on the cost of crude. Oil must remain above a breakeven point of approximately $32 a barrel for the process to be profitable. If the price of oil falls below $30 for a sustained period of time, the liquefaction plant may prove to be a costly albatross. But this is a risk China is more than willing to take, especially given the boost in energy security that internal production provides. As China continues on a path of dramatic growth, reliance on oil imports is expected to grow steeply in percentage terms as well, so alternative energy investments would do well just to keep pace with this trend; if oil imports represent less than half of consumption in the year 2020, China will have won an important strategic victory.

The winners and losers in China’s quest for energy security revolve around transport, exploration and technology. China’s demand for oil imports will rise inexorably over time, even as their internal energy sources come on line. This will create a rising demand for tankers, which in turn may benefit shipbuilders over the long cycle. As oil economics turn in favor of further exploration, there will be more opportunity in development and wildcat-style exploration projects, with big profits to the winners and heartbreak for those who come up dry. Look for the oil majors to participate indirectly in any exploration boom as well, spreading their risk through funding and backing of smaller players.

And of course, alternative energy technology is coming into its own. For the past few decades, alternative energy was simply not an economically viable option: Crude oil was too inexpensive, the initial development costs too high, to take alternatives seriously. But now, the development seeds are being sown, with compelling economics on the horizon for fossil fuel substitutes. In this arena, the companies positioned to profit most are those with hands-on intellectual property…alternative technologies that can be sold, licensed or leased but not easily copied or stolen, due to implementation requirements and need for hands-on expertise.

With the 20th century’s books now closed, China looks to the 21st…and they know it is their time. In this new century, the dragon will rise again. As investors, we ignore China’s destiny at our peril. Whether we see China as friend or foe is irrelevant; in fact, whether or not China fully succeeds in its ambition is irrelevant. What is certain is that China’s strategic actions, and the resulting reactions, will dramatically alter the global landscape. We are in the beginning stages of a sea change.

Regards,

Justice Litlefor The Daily ReckoningMarch 09, 2005

Our supply of oil can’t last forever…the day that the world runs out of gas could come a lot sooner than you think, putting everyone’s way of life in jeopardy – unless you are among those savvy energy investors that will actually profit from the turmoil.

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall, 2004). In addition, Justice Litle has been quoted in the Wall Street Journal and by multiple financial newswires, such as Dow Jones and Future Source.

Everything is just peachy. We don’t deny it. Spring is coming. The snow is melting in England and France.

Stocks are up. Houses are up. Even employment is up.

But what’s this? What are these new jobs? And why aren’t people earning more money from them? After a recession, typically employment rises and so do incomes. This "recovery" is 39 months old. It hasn’t produced as many jobs as we were expecting. And the latest numbers show that even those it has produced are not very good ones.

The fastest growing categories are administration, health care, construction, real estate, and restaurants. Many of the new jobs, in other words, involve building houses for people and serving them dinner. Nearly all of them are related to consumption…and practically none of them help ease America’s trade deficit. Nor do they help Americans out of their holes of debt. Just the contrary – it is as if Americans had been put to work digging themselves deeper!

In January, consumer debt rose twice as fast as expected, up $11.5 billion to a total of $2.12 trillion. Households borrowed in order to keep up appearances, because their earnings did not keep up with their consuming ambitions. In 2004, despite what looked like decent job growth, wages were no higher than they were at the bottom of the recession in November of 2001.

Meanwhile, costs are rising. Everything that can’t be made in China, or done in India, seems to be going up in price. Anyone who earns his wages making gadgets and geegaws in America is unlikely to see much income growth over the next three or four decades; he’s competing with 3 billion Asian workers. The Asians are driving prices down, not up. Even office workers are feeling the wage competition. More and more, Indians are processing America’s tax forms, doing our architectural plans, handling insurance paperwork, and running customer service offices. Workers with white collars are not likely to see much wage growth either.

Their incomes may be stagnant, but their costs of living are still moving up. Oil is at $54.59 per barrel. An Associated Press article estimates pump prices of about $2.15/gallon this summer. Gold is back at $441. Almost all commodities are soaring…with copper near 20-year highs.

The dollar, not by coincidence, is sinking. A euro cost $1.33 this morning. A simple house in La Jolla, California cost a million of them.

But the dirt flies…as millions of consumers continue to dig downward. And never has the ground yielded so readily. CNN Money reports that 42% of first time house buyers put zero down. Nearly 70% put down less than 10%. And the mortgage industry has come up with new, more efficient tools, such as the "minimum payment" scheme, which is like an automatic "ditch witch" for consumer. The borrower makes such a small payment on his loan each month it doesn’t even cover the interest. His loan balance grows without doing a thing.

Bring out the backhoes and excavators. Total consumer credit in America is at 305% of GDP. A bigger hole has never been dug. Still, it grows larger every day. Dandy. Just dandy.

More news, from our team at The Rude Awakening…

————–

Tom Dyson, reporting from Baltimore:

"With the Dow having broken 11,000 for the first time in over three years, is it time to start getting bullish again? We borrow a technique from Benjamin Graham to estimate fair value…"

————–

Bill Bonner, with more views from London:

*** "Asian banks cut exposure to U.S. dollar," says a Financial Times headline. The FT refers to the Bank of International Settlements, which reports that India has lightened up on the dollar over the last three years. Dollar reserves in India fell from 68% at the beginning of 2002, to only 43% today. In China, the dollar portion of foreign reserves fell from 83% three years ago, to 68% today.

"So when will the Fed stop raising rates? Sifting through pages of Fedspeak and Greenspanese is not likely to give you an answer. But here is an interesting supposition by the chief investment officer of FX Concepts, John Taylor. He writes that the Fed will raise rates "until there is a financial accident, one that is scary enough that the Fed starts loosening them again."

"And when and where will that financial accident be? Ah, that is the question. Will it be in Fannie Mae? Or the banking sector? Or some crisis among over-indulged U.S. consumers? More likely it will surprise us and involve some obscure names that no one knows today, but will be on everyone’s lips tomorrow."

*** Lenders may be reckless, but your fellow co-op owners are growing cautious. A friend sends this note from the Big Apple:

"In New York, you no longer look like a good risk if you’re only hauling in a $1 million or so a year. I guess since the banks won’t apply standards to loans, somebody has to. And what strict standards they are.

"To get a New York apartment these days, some buildings are asking for three years of mortgage payments and maintenance fees (typically in the range of $500-$1000 a month on top of the mortgage) before the board will approve an apartment purchase.

"In some places, they even want three times the cash value of the apartment sitting in an escrow account, as a buffer against God knows what. Maybe they know something more wicked than we imagine this way comes."

*** "Dad, I just don’t know," said Maria yesterday. "I don’t feel like it’s the real thing. But I want it to be the real thing. So, I don’t want to tell him that it’s not the real thing. But I can’t tell him something that isn’t true. And I can’t pretend it’s the real thing when it doesn’t quite feel like the real thing. Do you know what I mean?"

"Maria," Dad replied. He gives advice on many subjects, all of it at least as good as his financial advice. "You’re too young to have a boyfriend. You’re only 19. Wait another 10 years or so…"

"Oh, Dad…this isn’t funny. I don’t know what to do. And I feel like I have to do something. I mean, he’s really great. He’s Greek, you know. And he looks like a Greek god. I’m not kidding. But he might be a bit of a nut. I’m not sure. But you like people who are a bit nutty. They fit right in with the rest of the family. And he’s really wild about me. And his mother is town. And I’m going to meet her, tomorrow, probably."

"Just calm down. You don’t have to do anything. If it doesn’t feel like the real thing, then it’s definitely not the real thing. That doesn’t mean it won’t become the real thing. But just take your time. Relax. There’s no hurry. If it becomes the real thing, well, great. But if it doesn’t that’s great too. Just don’t put yourself in a position where you have to pretend…or have to try to make yourself feel something you don’t really feel. The worst thing you could is to lead him…and yourself on…then, it would be a real mess.

"Above all, try to maintain your dignity. You might need it. And when do I get to meet him? I’d like to give him a warning…"